Accounting method choice cuts both ways.

Author:Kebodeaux, Keith

Although small business taxpayers usually prefer to use the cash method of accounting, some, for whom considerations of accelerating deductions weigh paramount, might prefer to use the accrual method instead. Or they might elect it inadvertently. But they can also regret that choice (or accident) with respect to income, especially, for example, in the case of a business with a limited cash flow that receives a promissory note in payment.

In a recent Tax Court case, King Solarman, Inc., T.C. Memo. 2019-103, a corporate taxpayer elected the accrual basis of reporting in its initial tax return and failed to establish a justification for cash-basis accounting. The taxpayer was required to utilize inventories and the accrual method. Consequently, the deferred proceeds of a bulk sale of inventory were income in the year of delivery and passing of title, and sales of inventory were not eligible for installment-sales treatment. The taxpayer was not liable for an accuracy-related penalty, however.

The taxpayer, King Solarman Inc. (KSI), was a C corporation formed in 2011 to manufacture and sell mobile solar-powered lighting towers used as temporary lighting. On Schedule K, Other Information, of its initial Form 1120, U.S. Corporation Income Tax Return, for the fiscal year ended April 30, 2012, KSI represented that it was an accrual-basis taxpayer and continued to do so for tax years 2013-2015. It did not file a Form 3115, Application for Change in Accounting Method, seeking treatment as a cash-basis taxpayer. The returns for all four tax years reflected various accrued receivables and payables, consistent with the accrual method of accounting.

The IRS examined the return for the fiscal year ended April 30,2015. In that year, KSI sold 162 solar towers to Solarman Fund I LLC (the Fund), an investment entity organized by the CEO and principal of KSI. Through a series of intermediary entities, the towers were ultimately subleased to end users. The total purchase price to the Fund was $7,938,000, payable in two cash installments totaling $2,143,260 and the execution of a promissory note in the amount of $5,794,740. In fiscal year 2015, the Fund made cash payments of $2,268,814. KSI's 2015 ledger reflected sales of $2,268,814 and "deferred sales" and "accounts receivable/note" of $5,669,186. Title to the towers passed to the Fund upon delivery of the note and the first payment. Approximately 60% of KSI's 2015 sales were to the Fund.

In its 2015 tax...

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